Adam Smith Meets Climate Change

How the theory of moral sentiments could be applied to cap-and-trade greenhouse-gas emissions.

Despite all the attention to domestic oil drilling, Obama and McCain are not that far apart on climate change—both candidates support a cap-and-trade system to limit U.S. greenhouse-gas emissions. And neither candidate has told us much about how they will get the rest of the world on the cap-and-trade bandwagon. That challenge deserves more focus—unless we can entice fast-growing emitters like China, India, and Brazil into a climate change treaty as full participants, even complete energy independence in this country will be little consolation in a warming world. We think Adam Smith may have had a suggestion for how to think about this problem—and it's more than just an invisible hand.

For 30 years now, officials have been groping toward a system in which greenhouse-gas emitters all around the world can trade permits. GHG reductions achieve the same global atmospheric benefit regardless of where they occur, but because industries and firms have different costs of reduction, it makes economic sense to allow them to trade permits. That way we can lower emissions for less money.

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But a crucial sticking point is figuring out how to initially allocate emissions permits among the various countries of the world. Generally speaking, richer nations want permit allotments that track historic emissions rates—essentially locking in their economic advantage by awarding permits based on how much a country is already emitting. Developing countries, in contrast, want permits allocated according to population size, with every person on the planet getting equal emissions rights. Some representatives from poorer nations also point to the fact that countries have not contributed equally to the existing problem of global warming. They argue that the countries most responsible for the current state of affairs, like the United States, should get the fewest permits, since they have already spent their share of the planet's GHG budget.

Whatever the merits of the arguments, any attempt to load this kind of ethical discussion into the decision of how to allocate GHG permits spells diplomatic disaster. It leads back to the same game of GHG chicken we've been playing for years.

And that's where Adam Smith comes in. In addition to his famous arguments in favor of markets and liberalized trade, Smith also had a well-worked-out theory of moral behavior, one that was not so neatly separated from his economic thought as we treat it today. For example, Smith's arguments in favor of free trade included an assumption that owners of capital would naturally prefer domestic to foreign industry, even if the latter offered higher returns. Smith thought this was a good thing because it reflected the moral sentiments that ultimately help make markets work.

Today, capital chases investment opportunities all over the globe with little sense of social allegiance. Nevertheless, other ways of fulfilling Smith's vision have emerged: Firms, activists, and others have sought to reinfuse the market with moral content by giving consumers information about the circumstances in which products are produced. Sweatshop-free clothing, shade-grown coffee, fair-trade bananas, electricity generated from renewable resources—demand for these kinds of goods and services is spreading throughout the marketplace and blurring boundaries between citizen and consumer, government and economy, local and foreign. The market is starting to look as morally rich as it did to Adam Smith, only on a global basis.

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So here's the proposal: Rather than debate endlessly about how to carve up the spoils from just one global GHG currency, why not separate GHG permits into different brands based on how seriously they take the question of climate justice? Imagine an annual GHG cap that is subdivided into two categories. First, each country would receive a share of "regular" permits based on historic emissions rates or whatever base-line allocation method emerges from international negotiations. Second, each country would receive "justice" permits based on some formula that takes into account factors like population size and previous contributions to climate change.

The easiest approach to allocating justice permits would follow the preferred approach of developing countries—i.e., "the bigger your population, the more permits you get." Call this the "distributive justice" approach. A more ambitious formula would add a further tilt in favor of developing countries on account of unequal past contributions to the present GHG buildup. Call this the "distributive plus corrective justice" approach. No doubt there would be diplomatic battles about how precisely to fix the allocation formula, but at least those battles would no longer be focused, all-or-nothing, on a single climate currency.

Creating a separate market for justice permits also would offer the prospect of generating more money per permit for developing countries. Both regular and justice permits would entitle the holder to emit a ton of CO2 and both types would be fully tradable, but the justice permits would carry with them the right to advertise that goods and services were produced using the more equitably allocated emissions rights. The moral sentiments of consumers would then determine whether justice-branded products could be sold at a premium. For instance, we envision gas pumps of the future that give consumers a choice between "regular" and "justice added" brands. A premium price for justice brands would translate into compensation for emissions inequality.

The concept might seem a bit too abstract for consumers at first. But products from sustainably managed forests and fisheries probably also seemed abstract at one time, yet now they fill the shelves at mainstream stores like Home Depot and Wal-Mart. These firms know that the consumers most likely to be attracted to "justice" branding are also the ones willing to invest the time and energy to understand the brand's meaning. A customer might not look at a justice-branded sneaker and say to himself, "Hey, great, this was produced with carbon credits obtained via a progressive cap-and-trade system that imposes a penalty on richer nations that have been polluting for a longer time!" But he might get the bigger message—that the logo represents a larger system for reducing greenhouse-gas emissions while giving less-developed nations a chance to catch up in global markets.

At a time of high energy prices and a reeling economy, this proposal may sound a tad Pollyanna-ish, but consider the fact that the voluntary carbon offset market more than tripled in value last year to $331 million, according to one recent report. Our proposal would allow GHG altruism to continue in the coming carbon-constrained economy, and it would do so with fewer transaction costs and greater reliability than the current ill-defined and poorly monitored offset market.

This is a once-in-a-species opportunity. The global architecture necessary to produce a trading scheme is already being built. Whatever allocation of GHG emissions rights is eventually chosen will require a system for reporting, monitoring, and trading that could easily accommodate additional permit variations along the lines of our proposal. Consumers have moral sentiments about climate change. They just need a hand expressing them.